Inflation and retirement: Will your savings be enough?

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The goal of saving for retirement is to supplement the income you’ll receive from government pension plans (like the Régie des rentes du Québec and the Canada Pension Plan) and private pension plans (former employers) to maintain your lifestyle after retirement.

As we saw in the previous article, deciding how much to withdraw from your savings each year is a big decision. The method you choose for withdrawing your additional annual income will also play a key role in determining whether your savings are likely to last.

This likelihood depends on three factors: First, the composition of your savings portfolio: the higher the weighting of shares, the higher the potential returns—and the higher the risk. Second, market fluctuations outside of your control: if markets are doing well during your withdrawal phase, your savings are more likely to go the distance. Lastly, how will you calculate your additional annual income: do you want to adjust amounts by 100% of inflation, 50% or not at all? If you opt to fully adjust your withdrawal rate for inflation, your buying power will remain the same, while the other two options will lead to a decrease in buying power over time. In other words, if you want to withdraw an initial amount of $60,000 and you choose to fully adjust for inflation, how likely are your savings to last for the next 25 years or more?

Impact of inflation

We’re going to address this last question here, by assessing the impact of adjusting for inflation on the likelihood of savings lasting throughout retirement. Let’s take Ms. Ling as an example. She plans to retire in two years and has had a great career in communications as a self-employed worker. She’s decided on a 25-year withdrawal phase and wants to withdraw an initial amount of $72,000 after tax as her additional annual income. By retirement, she expects to have saved about $1,117,000, invested as follows:

RRSP and Locked-In Retirement Account (LIRA): $730,000

TFSA: $62,000

Non-registered accounts: $325,000

The overall allocation of Ms. Ling’s portfolio is as follows (assuming it doesn’t change):

Cash products and GICs: 5%

Fixed-income securities: 65%

Shares: 30%.

To simplify [1], let’s assume that the RRSP and LIRA are composed of fixed-income securities (like government bonds), the TFSA is exclusively composed of shares, and the non-registered accounts are split between GICs and shares. We’ll also assume that Ms. Ling will withdraw her savings in this order: funds from the non-registered accounts first, then her TFSA, then her RRSP and LIRA.

The following graph shows changes to additional annual income based on the degree of adjustment for inflation. When withdrawals are fully adjusted for inflation (maintaining buying power), the withdrawal rate increases from $72,000 to almost $110,000 over 25 years, which is a major shortfall to make up through savings.

The graph shows how the adjustment for inflation impacts the likelihood of Ms. Ling’s savings lasting 25 years at the withdrawal rate she wants:

When the rate is fully adjusted, there is less than half a chance of her savings lasting. This likelihood increases to about 57% if Ms. Ling keeps her withdrawal rate the same. Adjusting her withdrawals by 50% leaves her with a 53% chance of success.

Possible solutions

Choosing how much to adjust for inflation during the withdrawal phase is not the only factor determining whether retirement savings will last. To increase her chances, Ms. Ling could choose to reduce her initial withdrawal amount (and subsequent withdrawals), shorten the withdrawal phase, or opt for a higher risk strategy in her portfolio in the hopes of earning better returns. There are pros and cons to each choice. If she reduces her retirement income, she’ll have to live more modestly for several years. If she shortens the withdrawal phase (e.g. from 25 to 20 years), she’ll stop benefiting from the additional retirement income much sooner, which could be a problem as health care costs tend to increase with age. And while it might seem like a good idea to take on more investment risk to counteract inflation, being at the mercy of market fluctuations is not likely to bring Ms. Ling peace of mind.

[1] Please note that this is an approximate analysis that does not take into account various tax considerations. Nevertheless, it shows how adjusting for inflation can impact the probability of outliving your retirement savings. The assumptions underlying the projected returns are available on request.

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